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aceventura3 · 06-24-2008, 01:26 PM

Lately we have had many people saying speculators are driving the price of oil. I read a lot but no one explains how they think this is happening other that to say speculators are a higher percent of the futures market now than in the past. I am trying to understand how speculators can actually have an impact on prices. As I write this I might answer my own question, or someone with more insight may be able to help.

First, I think of a group of oil producers (OP), a group of speculators (S), one million barrels of oil, and oil refineries who would purchase and process the oil (OR).

Let say we have a direct market - OP delivers oil to OR. The OR pays a spot market price based on the oil available - supply, and what they need - demand. Let's say that price is $50 per barrel. And let's say that is going to be a constant, the real price (intrinsic price) based on supply and demand. All other things being equal in this market, with no risks, i.e. - political risks, shipping risks, inflationary risks, regulatory risks, etc. If we try to introduce S, there is no profit potential for them. If S could sell the oil for $51, why would the OP let the S make that dollar. Or if the S could purchase oil for $49 why would the OR let the S make that dollar? So in a market with no risk, there is no room for speculators. Speculators can not have an impact on price in a efficient market with no risk.

Now if we add risk. We have OP who may want to protect the downside. They may realize, in the future oil demand may go down. They may want to obtain money today for delivery at a future date (perhaps to fund war, fund investment in other things or more oil exploration). Introduce S. They are willing to take the risks of future delivery. They charge a price for this. The price has two components, profit and a risk premium. The OP may have to sell the futures oil contract at $45. Then the speculator sells the oil at $50 to the OR at the future date. The market works, all knowns are on the table, everyone is happy.

On the other hand we have the OR, who may want to manage risk. First they could become a S, and buy the futures contract at $45. But let's say the OR want to minimize the risk of future price increases in the market. They want to make sure they have an available supply at a known price. Again, the S can come in and assume the risk. They are willing to sell a futures contract to the OR at a price today for future delivery. Again this futures contract has two components, profit and a risk premium. Perhaps that contract sells for $55. The market works, all knowns are on the table, everyone is happy

So, the two price components involved with S is profit and risk premium. What happens if either of these components gets out of line?

Let's say there are more and more S's that come into the market all wanting to buy futures contracts for delivery of one million barrels of oil in 60 days. They all flock to the OP, bidding up the price of oil. Let's say they bid up the price to $130 per barrel for that future delivery. The intrinsic value of that oil is $50 per barrel, so we have a risk and profit premium of $80. What does the OR do? All other things being equal and if the OR had no options and they wanted to buy that futures contract on the day it peaked at $130, they would have to buy the oil at $130. If they then could pass the increased price on to consumers the $130 price would be supported.

What if the OR had other sources of oil? They could buy from those other sources, perhaps direct from the OP at a price less the profit for the S. Perhaps they could wait, and buy on the spot market for $50. Becuase we know that the S can not take delivery of one million barrels of oil so the closer we get to the delivery date the more incentive they have to lower the price and sell the contract.

What about the OP? Why would they sell their oil to S for less than $50, knowing that S can sell the oil to OR for $130? Or why would the OR buy at $130 when they could buy at $50 or less?

So, I am thinking at best S can only have a short-term impact on price and that eventually price will reflect the real intrinsic value. I think competition among S will in time lower profit margins to reasonable levels. However, I think the risk premium, is what it is, and that the risk premium is what is really driving the price.

06-24-2008, 01:26 PM	#29 (permalink)
aceventura3 Junkie Location: Ventura County	Lately we have had many people saying speculators are driving the price of oil. I read a lot but no one explains how they think this is happening other that to say speculators are a higher percent of the futures market now than in the past. I am trying to understand how speculators can actually have an impact on prices. As I write this I might answer my own question, or someone with more insight may be able to help. First, I think of a group of oil producers (OP), a group of speculators (S), one million barrels of oil, and oil refineries who would purchase and process the oil (OR). Let say we have a direct market - OP delivers oil to OR. The OR pays a spot market price based on the oil available - supply, and what they need - demand. Let's say that price is $50 per barrel. And let's say that is going to be a constant, the real price (intrinsic price) based on supply and demand. All other things being equal in this market, with no risks, i.e. - political risks, shipping risks, inflationary risks, regulatory risks, etc. If we try to introduce S, there is no profit potential for them. If S could sell the oil for $51, why would the OP let the S make that dollar. Or if the S could purchase oil for $49 why would the OR let the S make that dollar? So in a market with no risk, there is no room for speculators. Speculators can not have an impact on price in a efficient market with no risk. Now if we add risk. We have OP who may want to protect the downside. They may realize, in the future oil demand may go down. They may want to obtain money today for delivery at a future date (perhaps to fund war, fund investment in other things or more oil exploration). Introduce S. They are willing to take the risks of future delivery. They charge a price for this. The price has two components, profit and a risk premium. The OP may have to sell the futures oil contract at $45. Then the speculator sells the oil at $50 to the OR at the future date. The market works, all knowns are on the table, everyone is happy. On the other hand we have the OR, who may want to manage risk. First they could become a S, and buy the futures contract at $45. But let's say the OR want to minimize the risk of future price increases in the market. They want to make sure they have an available supply at a known price. Again, the S can come in and assume the risk. They are willing to sell a futures contract to the OR at a price today for future delivery. Again this futures contract has two components, profit and a risk premium. Perhaps that contract sells for $55. The market works, all knowns are on the table, everyone is happy So, the two price components involved with S is profit and risk premium. What happens if either of these components gets out of line? Let's say there are more and more S's that come into the market all wanting to buy futures contracts for delivery of one million barrels of oil in 60 days. They all flock to the OP, bidding up the price of oil. Let's say they bid up the price to $130 per barrel for that future delivery. The intrinsic value of that oil is $50 per barrel, so we have a risk and profit premium of $80. What does the OR do? All other things being equal and if the OR had no options and they wanted to buy that futures contract on the day it peaked at $130, they would have to buy the oil at $130. If they then could pass the increased price on to consumers the $130 price would be supported. What if the OR had other sources of oil? They could buy from those other sources, perhaps direct from the OP at a price less the profit for the S. Perhaps they could wait, and buy on the spot market for $50. Becuase we know that the S can not take delivery of one million barrels of oil so the closer we get to the delivery date the more incentive they have to lower the price and sell the contract. What about the OP? Why would they sell their oil to S for less than $50, knowing that S can sell the oil to OR for $130? Or why would the OR buy at $130 when they could buy at $50 or less? So, I am thinking at best S can only have a short-term impact on price and that eventually price will reflect the real intrinsic value. I think competition among S will in time lower profit margins to reasonable levels. However, I think the risk premium, is what it is, and that the risk premium is what is really driving the price. __________________ "Democracy is two wolves and a sheep voting on lunch." "It is useless for the sheep to pass resolutions on vegetarianism while the wolf is of a different opinion." "If you live among wolves you have to act like one." "A lady screams at the mouse but smiles at the wolf. A gentleman is a wolf who sends flowers."